Introduction
Charitable giving is fantastic! Why not give some of your assets to improve a part of our world? And while you’re at it, why not save a few bucks in income taxes? As is to be expected, this requires some thoughtfulness. For some people, this can drive significant tax savings.
Lay of the Land after Tax Reform
The December 2017 tax reform legislation (often referred to as “tax reform,” the Tax Cuts and Jobs Act, or “TCJA”) significantly altered the landscape for claiming itemized deductions. For 2017, before tax reform became effective, the standard deduction for single taxpayers was $6,350 and $12,700 for married filing joint (“MFJ”) taxpayers. Thus, in order to claim itemized deductions, the taxpayer’s total itemized deductions (such as mortgage interest, state and local taxes, and charitable contributions) had to exceed these thresholds for the 2017 tax year. Many itemized simply because their state tax withholding alone put them in a position to equal or exceed these thresholds. This matters with respect to charitable contributions because if you don’t itemize, you don’t get any tax benefit for your charitable contributions.
Post tax reform, things are different. First, tax reform significantly increased the standard deduction. In 2018 the standard deduction increased to $12,000 for single taxpayers and $24,000 for MFJ taxpayers. Second, the deductible amount of state and local taxes (including individual income and property taxes) is capped at $10,000 per tax return. Thus, for MFJ filers and who paid $10,000 or more in state and local taxes still need $14,001 more in itemized deductions (mostly mortgage interest and charitable contributions) to itemize.
Thus, many will now find that they will take the standard deduction instead of itemizing. The downside is losing the tax benefits of charitable contributions. However, there are several planning opportunities whereby taxpayers can still reap significant income tax benefits of charitable contributions.
Donor Advised Fund (“DAF”)
Ideal for: People (a) with standard deductions very close to their itemized deduction amount or greater and (b) who makes regular, predictable (weekly, monthly, quarterly, or yearly) donations to charities or plan to donate to charities in the future.
How it Works and Tax Benefits: A donor establishes a donor advised fund with a financial institution that has established a charitable institution for the purpose of managing donor advised funds. The donor provides assets to the DAF. Then the donor “advises the fund,” meaning that he or she requests that the fund make disbursements to particular charities in particular amounts. While the institution in control of the DAF could, theoretically, reject the request, as a practical matter as long as the requested charity is a valid, properly registered section 501(c)(3) public charity, the DAF will send money to the charity. There is no explicit time requirement for the DAF to disburse its funds, and thus the DAF can make donations to public charities for several years.
The DAF gives the donor a significant tax benefit in today’s high standard deduction environment. The donor receives an upfront tax deduction for the fair market value of the assets contributed to the DAF in the year of the contribution. It is a way for a donor to bring forward, for tax purposes, the charitable deduction for contributions to a charity or charities occurring over several years. For tax purposes, the DAF aggregates several years’ worth of charitable contributions in a single year without a future tax cost, since the donor is covered by the high standard deduction in the later years when the DAF contributes to the charities.
Example: Jane and Joe Smith attend Mass every Sunday at St. Joseph’s Catholic Church. Every time they attend Mass they put money in the collection basket as a charitable donation. In November 2018 Jane and Joe add up their projected 2018 itemized deductions (mortgage interest, state taxes, and charitable contributions) and project that they are at $24,000, exactly the same as the standard deduction. They anticipate their itemized deductions in 2019 will only be $18,000. If they make a $5,000 contribution to a DAF in early December 2018, their 2018 itemized deductions will increase to $29,000. Going forward until the DAF is exhausted, the DAF will make disbursements to St. Joseph’s instead of the Smiths making the contributions.
The contribution to the DAF provides the Smiths a significant tax benefit in 2018 ($5,000 reduction to taxable income) and will cost them nothing in 2019, since they will take the standard deduction for 2019 regardless. Forgoing 2019 tax deductions (by accelerating them to 2018 through the DAF contribution) did not cost Jane and Joe Smith any additional tax in 2019 and saved them tax in 2018.
If Jane and Joe were initially at $18,000 in 2018 itemized deductions instead of at $24,000, a $5,000 DAF contribution would not have made sense, because the Smiths would not have enough itemized deductions ($23,000) to exceed the standard deduction.
Another DAF tax benefit for the donor is that income earned by the DAF (i.e., interest, dividends, and capital gains) is not taxable to the donor. That income increases the charitable impact of the original DAF contribution.
Some caveats: First, a transfer to a donor advised fund is an irrevocable transfer. While the donor retains the right to advise the DAF regarding disbursements to charities, the donor cannot reclaim the funds for him or herself. Second, the institution holding the DAF will charge fees against the DAF assets. Finally, institutions usually require a minimum initial contribution in order to form a DAF.
Donation of Appreciated Stock
Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds.
How It Works and Tax Benefits: Donations of appreciated securities to an eligible charity allow the donor to deduct the entire FMV of the stock, up to 30% of adjusted gross income (“AGI”). Alternatively the donor can elect to deduct the basis of the stock, up to 60% of AGI. Further, the donor avoids recognizing the capital gain on the securities on his or her tax return. Thus, this strategy has a benefit from an income perspective (avoids recognition of a gain) and a benefit from a deduction perspective (the itemized charitable deduction).
For those looking to get rid of securities that no longer fit their desired investment portfolio, this can be a very tax efficient manner to do so.
Note that built-in loss securities should not be donated to charities. Rather, they should be sold first in order to trigger the capital loss for tax purposes, and then the proceeds should be donated to the charity.
Hyper Donor Advised Fund
Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds that make routine charitable contributions or are interested in making future charitable contributions.
How It Works and Tax Benefits: The “hyper donor advised fund” (my pet name for this technique) simply combines the first two planning techniques.
Here is an example: Sammy owns 100 shares of Kramerica Industries. It is worth $50 per share ($5,000 total) and Sammy paid $5 per share ($500 total). Sammy has determined that he will have $11,000 of itemized deductions in 2018 and is likely to have no more than that in 2019 and 2020. Sammy plans to donate approximately $1,000 to his favorite charity, The Human Fund, annually.
Sammy can transfer the appreciated Kramerica stock to a DAF in December, 2018 and claim $16,000 of itemized deductions on his 2018 tax return without lowering his tax deductions in 2019 and 2020. Sammy also avoids recognizing on a tax return the $4,500 ($5,000 less $500 cost basis) gain he has in the Kramerica stock. The DAF can sell the Kramerica stock, invest the proceeds, and make, at Sammy’s recommendation, annual donations to The Human Fund.
Qualified Charitable Distribution (“QCD”)
Ideal for: (a) those 70 ½ or older and (b) those nearing age 70 ½ who cannot yet do a QCD, but should consider future QCDs when doing current tax planning.
How it Works and Tax Benefits: Donors 70 ½ years old and older can contribute up to $100,000 annually to charity directly from their traditional IRA without the amounts contributed being included in taxable income. The main advantage of this strategy is that the taxpayer’s “required minimum distribution” (“RMD”) can be satisfied by the QCD without a taxable income inclusion to the donor. While the donor does not receive a charitable deduction, that is made up for by excluding the amount of the QCD from taxable income. Given the new higher standard deduction, the taxpayer essentially gets the benefit of a charitable deduction without having to itemize.
While the QCD can satisfy the RMD, it does not have to – if a taxpayer has a RMD of $10,000 for the year but wants to make a $20,000 donation from their IRA to a charity, they can do so and the entire $20,000 amount qualifies for QCD treatment.
QCDs also present a planning opportunity for those not yet 70 ½ years old. Many do Roth Conversions (converting traditional IRAs and other traditional accounts to Roth IRAs) prior to age 70 ½ to reduce future RMDs. Doing so creates current taxable income, but lowers the future balance in the traditional IRA or 401(k) such that in the future RMDs are lower. For those charitably inclined, they may want to limit current Roth Conversions designed to mitigate future RMDs, since future QCDs can be used to eliminate the tax impact of RMDs in the future. Thus, charitably inclined individuals in their 60s may want to leave some amounts in traditional IRAs for future charitable donations. Then, when they turn 70 ½ they can make QCDs to avoid RMD taxable income.
It is important to note that to qualify for QCD treatment, the donor must be 70 ½ or older on the date of the distribution. Second, gifts to private foundations and DAFs do not qualify for QCD treatment. Third, inherited IRAs qualify for QCDs as long as the beneficiary inheriting the IRA is 70 ½ or older at the time of the distribution.
Lastly, the charity should never give any token gift of appreciation for the QCD donation because the receipt of anything in return for the donation disqualifies the distribution from favorable QCD tax treatment.
Bunching Contributions
Ideal for: Charitably inclined people with excess cash at year end.
How it Works and Tax Benefits: For taxpayers at or over the standard deduction threshold near year end, it may be advisable to make next year’s planned charitable donations this year to accelerate the tax deduction and take advantage of the next year’s higher standard deduction. Similar to some of the above techniques, the technique picks a year to itemize deduction and then picks a year (or years) to utilize the standard deduction in a manner the optimizes the total tax deductions taken over a period of time.
Charitable Remainder Trust
Ideal for: Wealthy charitably inclined people looking for a large current tax deduction, often in cases where they have a one-time significant income event, such as the sale of a significant asset or business or a very significant bonus.
How it Works and Tax Benefits: Taxpayers can contribute assets to a trust whereby the donor receives the income from the trust assets for a period of time and a designated charity receives the assets of the trust at the end of a period of years. This technique gives the donor a large upfront one-time deduction based on IRS rules.
This is generally not a strategy very applicable in the FI community, but for certain wealthy taxpayers looking for a significant tax deduction and willing to engage the right legal and tax professionals, it can create significant benefits.
Conclusion
Charitable giving illustrates the need to always consider whether there is a tax angle to a transaction. Contributions, if structured in particular way, can provide significant tax benefits while fulfilling their main purpose — the improvement of society and the advancement of the charity’s eleemosynary cause.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.